What the ‘London Whale’ Is (Probably) Doing

In a conference call following this morning’s earnings announcement, JPMorgan Chase Chief Financial Officer Doug Braunstein basically laughed off the idea that a London-based trader in the bank’s chief investment office was engaging in large proprietary trades that were distorting the market in credit default swaps for investment grade corporate bonds.

Both Bloomberg and The Wall Street Journal reported last week that a trader named Bruno Iksil had built up a large long position in a derivative known as CDX.IG.NA, selling protection on a basket of investment grade (that’s the IG part) companies in North America (that’s the NA part). On their own, these trades would indicate a bullish stance on the bonds, a bet that they would strengthen and the price of protecting against defaults would fall. (If the price of protection falls, JPMorgan can buy protection itself, pocketing the difference between the price at which it sold protection and the price at which JP Morgan purchased it.)

There were objections from unnamed traders, presumably hedge funds that had taken the opposite position, essentially arguing that JPMorgan was engaging in prop trading in violation of the spirit of the Volcker Rule .

Iskil’s positions were reported large enough that they moved prices, so that buying protection on the index was cheaper than buying protection on the individual credits underlying the index.

Hedge fund traders reportedly started calling Iskil the “London Whale” and began placing a variety of bets against his positions. Many believed that his position was so large that he would have to lose money once the index and the underlying credits reverted to a more normal relationship.

JPMorgan has insisted that Iskil’s trades are not directional bets across the markets, but hedges against other risks on the company’s balance sheet.

In some ways, this is a surprising hedge for JPMorgan. The bank, one of the largest lenders in the U.S., is presumably already “long” corporate America just by virtue of its exposure to so many American borrowers. Selling derivatives that pay buyers if corporate credit quality in the U.S. deteriorates would seem to just double down, since being a protection seller in this market creates a synthetic long position in the underlying bonds.

Traders I spoke with say that Iskil is probably using the CDX trade as part of a strategy to hedge inflation rate risk. The clearest way to hedge inflation risk is to buy Treasury Inflation Protected Securities, or TIPS. But the yield on 10-year TIPS has been so low it has sometimes fallen into negative territory.

JPMorgan may be seeking to combine the inflation protection of TIPS without locking in the low yields by pairing its TIPS purchases with selling protection on CDX. The idea is to skim the higher yield offered in corporate bonds to balance out the low yield of the TIPS. This could even be somewhat self-financing, as the income from selling protection could be used to purchase the TIPS.

The Wall Street Journal reported earlier this week that Iskil has stopped making the trades that were rattling hedge fund traders. This could be because of all the unwanted attention he had attracted. It would also make sense if this was always a paired trade with TIPS. The spread between TIPS and ordinary Treasurys has narrowed recently, implying diminished inflation expectations. If JPMorgan is investing less in protection against inflation, it would need less of an overlay against the cost of this inflation — which would mean backing off the long position in the CDX.

JPMorgan hasn’t been very clear about what Iskil is doing, but this trade would explain why Iskil’s bosses view his trading as hedging rather than prop trading.